Bonds News

Bear Stearns CDO liquidation sparks contagion fears

NEW YORK (Reuters) - Even as Bear Stearns held out hope of keeping two hedge funds from collapsing, worries over their forced liquidation are reverberating through U.S. financial markets, raising concern about broader contagion.

So far the risks seem contained, but the fallout may be felt everywhere from leveraged buyouts, investment bank earnings and sales of collateralized debt obligations. Those securities have pushed sales of corporate and housing-related debt to record highs in the past year.

Merrill Lynch & Co. MER.N on Wednesday sold only $100 million of $850 million of highly rated collateral assets it auctioned after seizing them back from the Bear Stearns funds, said a person familiar with the auction.

Three other banks -- Goldman Sachs Group Inc. GS.N, JPMorgan Chase & Co. JPM.N and Bank of America Corp. BAC.N -- have closed out their positions with the funds.

High-grade CDOs trade infrequently because of their perceived safety relative to lower-rated securities that provide higher yield for investors. It might be difficult to sell such a large quantity, dealers and investors said. The concern is that a generalized markdown of CDO positions could be inevitable and spark a greater wave of selling.

“The problem is that marking down the assets to where the market will bid them may in fact be the right thing to do, but no one wants to take the loss,” said Jason Brady, who helps manage $4 billion in bonds at Thornburg Investment Management in Santa Fe, New Mexico.

Details about Merrill’s auction and efforts by Bear Stearns to offer $2 billion of CDOs were not immediately clear as possible buyers determine how to value the complex CDOs.

Some fund managers speculated the failure to sell the assets as intended indicated the dealers were largely disappointed with what they saw.

CDOs group debt based on credit quality to help diversify risk by placing the strongest debt at the top of the capital structure. In theory, the repackaged debt helps absorb weaker performance from riskier debt such as subprime loans.

“It seems like credit risk premiums are prone to increase in the near term, influenced to a great degree by the risk of marking CDO assets, not necessarily liquidating them,” said Christopher Sullivan, chief investment officer at the United Nations Federal Credit Union in New York.

The market has absorbed sales without incident, but lenders to hedge funds may still be hurt as they’re forced to remark positions, he said.

A benchmark subprime mortgage bond index fell to record lows this week, putting bond traders on edge about the prospects for spillover to other credit markets. The so-called “home equity asset-backed securities” are backed by bundles of loans to homeowners with the riskiest credit.

Fixed-income investors around the world have increasingly sought their higher yields over the past few years, leading dealers to allow greater production of the securities and CDOs with poorer quality collateral.

Standard & Poor’s financial shares fell 1.9 percent since the Bear Stearns troubles became public last week. Bear Stearns shares fell 5.5 percent, Goldman share dropped 4.6 percent and Merrill shares fell 4.3 percent.

The 10-year swap spread, a proxy for the outlook on corporate credit, widened as much as 4 basis points in the past two days above 60 basis points, near the highest since 2003.

Corporate bond spreads also increased to its widest levels over Treasuries since October, suggesting greater risk to investors.

“The market is really worried about a contagion,” said Michael Metz, chief investment strategist at Oppenheimer & Co. in New York. “It’s an open-ended black hole, and a lot of people are going to take to the sidelines until it’s clarified. Nobody knows how serious it is going to get.”

The sale of assets is an attempt by Bear Stearns to save hedge funds that suffered double-digit losses in April, based on bad bets in the $583 billion subprime mortgage bond market.

Merrill Lynch has seized $850 million of assets from the funds and tried to auction them off on Wednesday after a failed recapitalization, sources familiar with the situation said. A Merrill representative didn’t return a call to comment.

The CDOs placed for sale are mostly rated “AAA,” but at least one is rated “BBB,” in the lowest tier of investment-grade debt, according to bid lists.

Some of the assets also include so-called CDO squared structures, which are CDOs of CDOs and even more difficult to value.

“They only want to sell the higher-quality assets,” said Mirko Mikelic, a senior portfolio manager who oversees $5 billion in fixed-income assets for Fifth Third Asset Management in Grand Rapids, Michigan. “Right now there’s no trading going on for lower-rated securities.”